Capital Market Expectation Flashcards
Identify the process to formulate Capital Market Expectations
Step 1 : Determine the specific capital market expectation in line with the investors allowable asset classes and investment time horizon
Step 2 ; Analyze the historical performance of the assets to understand the drivers of the performance. We can then use these to forecast expected return performance.
Step 3 : Identify the valuation model to be used
Step 4 : Collect the data (input) that will be used in the model
Step 5 : Use judgment to make sure that the inputs are consistent with the asset class being use
Step 6 : Formulate capital market expectation
Step 7 : Monitor performance and use it to refine the process.
Define Cross-Sectional Consistency ?
Build a consistency across the asset classes in your portfolio in terms of risk and return characteristics.
Define Intertemporal Consistency ?
Consistency in the invesment horizon regarding portfolio decision
Explain the concept of Uncovered interest rate parity (UIP)
Exchange rate changes should equal differences in nominal interest rates.
Define limitation to using economic data when forecasting asset classes :
- Time lag between collection and distribution is often quite long.
- Data are often revised and the revisions are not made at the same time as the publication.
- Data indexes are often rebased overtime
Explain types of measurement errors and biases that can occur when forecasting asset classes :
Transcription errors : Misreporting or incorrect recording of information.
Survivorship bias : Occurs when manager or a security return series is deleted from the historical performance record of managers or firms. Deletions are often tied to poor performance and bias the historical return upward.
Appraisal Data : Illiquid and infrequently priced assets makes the path of returns appear smoother than it actually is (often the case with real estate securities)
Describe Anchoring bias, status quo bias, confirmation bias, overconfidence bias, prudence bias and availability bias
Anchoring bias : The first information received is overweighted
Status quo bias : prediction is highly influence by the recent past.
Confirmation bias : only information that is supporting the existing belief is considered.
overconfidence bias : past mistakes are ignored
prudence bias : forecasts are overly conservative
Availability bias : what is easiest to remember (ofter extreme event) is being overweight.
Describe the different variable to forecast the economic growth rate
Labor input : growth in labor force and labor participation
Total factor productivity
Capital deepening (Capital per worker)
Describe how the trend rate of growth can estimate the market value growth of equity
Short term : we combine Nominal GDP + P/E + earnings / GDP
Long term : P/E and Share of earnings in GDP cannot increase indefinitly, hence, market value of equity growth will be nominal GDP
Describe the use of econometric analysis for economic forecasting and identify advantages and disadvantages of the model
Econometric analysis will make the use of statistical methods to explain economic relationship and formulate forecasting models.
Advantages :
- Model can incorporate multiple variable
- Once the model is specified, it can be reused
- Output is quantified
Disadvantages :
- Model are complex and time consuming
- data may be difficult to forecast
Identify advantages and disadvantages of economic indicators to forecast economic outlook
Advantages :
- Easy to interpret
- Readily available
Disadvantages :
- Can be inconsistent
- Can give false signals
Describe what higher trend of growth means
It implies that the economy grow can grow at a faster pace before inflation become a major problem
Explain the relationship between interest rates, inflation, stock and bonds when we are in the initial recovery phase of the business cycle
Interest rates are low and can even decrease even more.
Deflation period
Stocks returns are starting to increase
Bond yields are at their bottom
Large output gap
Explain the relationship between interest rates, inflation, stock and bonds when we are in the early expansion phase of the business cycle
Interest rate starting to increase
low inflation
bond yield are slowly increasing
Stocks are growing at faster pace
Explain the relationship between interest rates, inflation, stock and bonds when we are in the late expansion phase of the business cycle
increasing interest rate
inflation is starting to increase
bond yield increase
stock increase but is volatile
No output gap
Explain the relationship between interest rates, inflation, stock and bonds when we are in the slowdown phase of the business cycle
Interest rate are at peak
inflation is still rising
Bond yields are peaking and possibly falling
Stocks are decreasing
Explain the relationship between interest rates, inflation, stock and bonds when we are in the contraction phase of the business cycle
Inflation is peaking
Interest rate are decreasing
bond yield are falling
stocks are decreasing but at the late stage of contraction, they can start to increase
Describe how do we calculate the neutral rate and what does it exhibit. Also, explain how we can use this rate to estimate the short term interest rate
Neutral rate is also know as the equilibrium rate. It the perfect balance between inflation and growth.
We can use the taylor rule to estimate the target short term interest rate :
Target short term rate = N rate + Expected inflation + (0.5 * (GDP Expected - GDP Trend) + 0.5 * (Expected inflation - Target inflation)
A small, developing country has pegged its currency to the US dollar. What is most likely to occur if investors lose confidence in the pegged currency and its value begins to decline?
The pegged currency will need to increase its short term interest rate to attract investors.
Identify the 3 main approaches to forecast fixed income returns
Equilibrium approach
Discounted Cash Flow (DCF)
Risk premium approach (building blocks)
For an investment horizon that is shorter than the Macaulay duration, what risk will be more dominant and how will it impact out investment if interest rate goes up
Investment horizon shorter than macaulay duration, more sensitive to capital gain/loss. Falling (rising) interest rates will result in a higher (lower) realized return.
Identify the different component in the building blocks approach for fixed income
- Shot Term risk free rate
- Term Premium
- Credit premium
- Liquidity premium
Identify factors that can influence the term premium component of fixed income returns
- Term premium is influenced by inflation. Higher inflation cause more uncertainty and increase the term premium.
Recession Hedge : When inflation is caused by strong aggregate demand, nominal bond returns are negatively correlated with growth, corresponding to low term premiums. When inflation is caused by aggregate supply, nominal bond returns are positively correlated with growth, corresponding to higher term premiums.
Supply and demand : The relative supply of short- and long-term default-free bonds determines the slope of the yield curve, which influences the level of term premiums.
Business Cycle : The slope of the yield curve and level of term premiums are also related to the business cycle.
Explain what characteristics does make liquidity higher for bonds
- Bonds that are issued at par or market rates
- New bond
- Large in size
- Issue by a well know issuer
Simple in structure
High credit quality
What are the signs that an emerging market is more susceptible to risk
Wealth concentration
Income concentration
Greater dominance of cyclical industries
Restrictions on capital flows and trade
Large amount of foreign borrowing in foreign currency
How can we estimate the well being of a foreign country fiscal policy
need to look at the deficit to GDP ratio. If greater than 4%, the country indicate potential credit risk. Also, we can look at the debt to GDP ratio - around 70% to 80% can be problematic
How much should an investor expect to receive from real growth rate from foreign market
At least 4%
Identity how we can estimate that a country may be overleveraged
If the foreign debt levels is greater than 50% of GDP. Also, if overall debt level of the country is more than 200% of current account receipt, that also exhibit risk.
How do we calculate the Grinold Kroner Model
Expected Equity Returns = D/P + %change in nominal earnings growth - %change in stock repurchases) + %change in P/E
For VERY long term horizon, %change in P/E and Share repurchases is 0
How can we calculate the Beta between i securities and global market
COV (Ri; Rm) / VAR (Rm)
or
Correlation (Ri ; Rm) * (Stand dev i / Stand dev m)
How do we calculate the Risk Premium of i securities (RPi) using the Singer Terhaar model
correlation (Ri;Rm) * Stand dev i * Sharpe Ratio m
What are key characteristics of the Singer Terhaar model
Assume that markets are either fully segmented or fully integrated. Developped country are usually between 75%-90% intergrated vs 50%-75% for developping country.
To calculate the RP of a country, we calculate the RP in a fully integrated (correlation (Ri;Rm) * Stand dev i * Sharpe Ratio m) and the RP of fully segmented (Stand dev i * Sharpe Ratio of local market - we can take the Sharpe ratio of global market if the local is not given). We then do a weighted average of the different RP.
Describe what’s the cap rate for real estate and how do we calculate it
Cap rate is the earnings yield of real estate. Cap rate is positively related to change in interest rate and vacancy rate.
NOI / property value
We can also derive the cap rate by = E(r) - NOI growth rate
During stable period, the long run NOI growth rate should be close to the GDP Growth.
If investor have a finite time period : E(r) = Cap rate + NOI growth rate - %change cap rate
What are the different risk premium for real estate assets
These include a term premium for holding long-term assets, a liquidity premium, a credit premium to compensate for the risk of tenant nonpayment, and an equity risk premium above corporate bond returns for the fluctuation in real estate values, leases, and vacancies.
Describe the adjustments that must be made before real estate can be use in equilibrium model such as the Singer-Terhaar.
1- The impact of smoothing must be removed from the data.
2- Incorporate an illiquidity premium to the model
How does trade in goods and services affects exchange rates
1- Trade flows - Large trade flows (imports) without large financing flows in foreign exchange markets likely indicates a crisis. The country that has a trade inflows deficit needs to be able to finance the deficit by either borrowing in the foreign currency or by having investment of that currency
2- Purchasing Power Parity :
3- Competitiveness and sustainability of the current account. : it is not the size of the current account balance that matters as much as the length of the imbalance.
describe what is capital mobility and how can we calculate it
Capital mobility : %change of exchange rate
% change in the exchange rate = Rate d - Rate f + (Term d - Term f) + (Credit d - Credit f) + (Equity d - Equity f) + (Liquid d - Liquid f)
Identify the different methods we can use to forecast volatility
Sample VCV Matrix
Factor Based VCV Matrices
Shrinking estimates
ARCH Models
What are the advantages and disadvantages of using a factor-based VCV matrices
Advantages :
Significantly reduces the number of required observations.
Correlations can be estimated from a few common factors.
Disadvantages :
The matrix is biased cause the inputs has to be estimated and will be misspecified.
The matrix is inconsistent
Describe what is the use of Shrinkage estimates
- Combination of factor based matrices and sample VCV matrix.
- Weighted average estimate of both models.
- Will be more accurate than the other model if well specified.
